Slide 1.3.1
1. Accounting for decision making
1.3 Cost-volume-profit
relationships
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.2
Introduction
This chapter examines one of the most basic
planning tools available to managers: cost–
volume–profit (CVP) analysis.
Cost–volume–profit analysis examines the
behaviour of total revenues, total costs and
operating profit as changes occur in the output
level, selling price, variable costs per unit or
fixed costs.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.3
Learning Objectives
1
2
3
4
Distinguish between the general case and a
special case of CVP
Explain the relationship between operating
profit and net profit
Describe the assumptions underlying CVP
Demonstrate three methods for determining
the breakeven point and target operating profit
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.4
Learning Objectives (Continued)
5
Explain how sensitivity analysis can help
managers cope with uncertainty
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.5
Learning Objective 1
Distinguish between the general
case and a special case of CVP
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.6
General case versus special
case of CVP
Using a general case of profit planning, we
realise that a business has many cost drivers
and revenue streams that are fundamental to
its profitability.
In CVP analysis, we assume a much more
simple model, where there are restrictions
on these setting, as outlined in the following
slides.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.7
Cost–Volume–Profit Assumptions
and Terminology
1
2
Changes in the level of revenues and costs
arise only because of changes in the number
of product (or service) units produced and
sold.
Total costs can be divided into a fixed
component and a component that is variable
with respect to the level of output.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.8
Cost–Volume–Profit Assumptions
and Terminology (Continued)
3
4
When graphed, the behaviour of total revenues
and total costs is linear (straight-line) in
relation to output units within the relevant
range (and time period).
The unit selling price, unit variable costs and
fixed costs are known and constant.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.9
Cost–Volume–Profit Assumptions
and Terminology (Continued)
5
6
The analysis either covers a single product
or assumes that the sales mix when multiple
products are sold will remain constant as the
level of total units sold changes.
All revenues and costs can be added and
compared without taking into account the
time value of money.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.10
Cost–Volume–Profit Assumptions
and Terminology (Continued)
Operating profit = Total revenues – Total Cost
Net Profit = Operating profit + Non-operating
revenues (such as interest revenue) –
Non-operating costs (such as interest cost) –
Profit taxes
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.11
Learning Objective 2
Explain the relationship between
operating profit and net profit
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.12
Operating Profit versus Net Profit
Operating profit statement emphasises
operating profit (contribution margin).
Revenues – Variable cost of goods sold –
Variable operating costs – Fixed operating
costs = Operating profit
Operating profit – Taxes = Net profit
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Slide 1.3.13
Operating Profit versus
Net Profit (Continued)
Financial accounting profit statement
emphasises operating profit.
Revenues – Cost of goods sold = Gross
Profit
Gross Profit – Operating costs = Operating
Profit
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.14
Learning Objective 3
Describe the assumptions
underlying CVP
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Slide 1.3.15
Assumptions of CVP Analysis
Assume that the shop Dresses by Mary can
purchase dresses for £32 from a local
factory; other variable costs amount to £10
per dress.
Because she plans to sell these dresses
overseas, the local factory allows Mary to
return all unsold dresses and receive a full
£32 refund per dress within one year.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.16
Assumptions of CVP Analysis
(Continued)
Mary can use CVP analysis to examine
changes in operating profit as a result of
selling different quantities of dresses.
Assume that the average selling price per
dress is £70 and total fixed costs amount to
£84,000.
How much revenue will she receive if she
sells 2,500 dresses?
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.17
Assumptions of CVP Analysis
(Continued)
2,500 × £70 = £175,000
How much variable costs will she incur?
2,500 × £42 = £105,000
Would she show an operating profit or an
operating loss?
An operating loss
£175,000 – 105,000 – 84,000 = (£14,000)
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Slide 1.3.18
Assumptions of CVP Analysis
(Continued)
The only numbers that change are total
revenues and total variable cost.
Total revenues – total variable costs
= Contribution margin
Contribution margin per unit
= selling price – variable cost per unit
What is Mary’s contribution margin per unit?
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.19
Assumptions of CVP Analysis
(Continued)
£70 – £42 = £28 contribution margin per unit
What is the total contribution margin when
2,500 dresses are sold?
2,500 × £28 = £70,000
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Slide 1.3.20
Assumptions of CVP Analysis
(Continued)
Contribution margin percentage (contribution
margin ratio) is the contribution margin per
unit divided by the selling price.
What is Mary’s contribution margin
percentage?
£28 ÷ £70 = 40%
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.21
Assumptions of CVP Analysis
(Continued)
If Mary sells 3,000 dresses, revenues will be
£210,000 and contribution margin would
equal 40% × £210,000 = £84,000.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.22
Learning Objective 4
Demonstrate three methods for
determining the breakeven point
and target operating profit
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.23
Breakeven Point
Breakeven point is the sales level at which
operating profit is zero.
At the breakeven point, sales minus variable
expenses equals fixed expenses.
Total revenues = Total costs
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.24
Abbreviations
USP = Unit selling price
UVC = Unit variable costs
UCM = Unit contribution margin
CM% = Contribution margin percentage
FC = Fixed costs
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.25
Abbreviations (Continued)
Q = Quantity of output (units sold or
manufactured)
OP = Operating profit
TOP = Target operating profit
TNP = Target net profit
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.26
Methods for Determining
Breakeven Point
Breakeven can be computed by using either
the equation method, the contribution
margin method or the graph method.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.27
Equation Method
With the equation approach, breakeven sales
in units is calculated as follows:
(Unit sales price × Units sold) – (Variable unit
cost × units sold) – Fixed expenses =
Operating profit
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.28
Equation Method (Continued)
Using the equation approach, compute the
breakeven for Dresses by Mary.
£70Q – £42Q – £84,000 = 0
£28Q = £84,000
Q = £84,000 ÷ £28
Q = 3,000 units
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.29
Contribution Margin Method
With the contribution margin method,
breakeven is calculated by using the
following relationship:
(USP – UVC) × Q = FC + OP
UCM × Q = FC + OP
Q = FC + OP ÷ UCM
£84,000 ÷ £28 = 3,000 units
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.30
Contribution Margin
Method (Continued)
Using the contribution margin percentage,
what is the breakeven point for Dresses by
Mary?
£84,000 ÷ 40% = £210,000
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.31
Graph Method
In this method, we plot a line for total
revenues and total costs.
The breakeven point is the point at which the
total revenue line intersects the total cost line.
The area between the two lines to the right of
the breakeven point is the operating profit
area.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.32
Graph Method
Dresses by Mary
£ (000)
245
Revenue
231 Breakeven
Total expenses
210
84
3,000
3,500
Units
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.33
Target Operating Profit
1
2
3
Target operating profit can be determined by
using any of three methods:
The equation method
The contribution margin method
The graph method.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.34
Target Operating Profit (Continued)
Insert the target operating profit in the
formula and solve for target sales either in
pounds or units.
(Fixed costs + Target operating profit)
divided either by Contribution margin
percentage or Contribution margin per unit.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.35
Target Operating Profit (Continued)
Assume that Mary wants to have an operating
profit of £14,000.
How many dresses must she sell?
(£84,000 + £14,000) ÷ £28 = 3,500
What £ sales are needed to achieve this profit?
(£84,000 + £14,000) ÷ 40% = £245,000
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.36
Learning Objective 5
Explain how sensitivity analysis can
help managers cope with uncertainty
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.37
Using CVP Analysis
Suppose the management of Dresses by
Mary anticipates selling 3,200 dresses.
Management is considering an advertising
campaign that would cost £10,000.
It is anticipated that the advertising will
increase sales to 4,000 dresses.
Should Mary advertise?
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.38
Using CVP Analysis (Continued)
3,200 dresses sold with no advertising:
Contribution margin
£89,600
Fixed costs
84,000
Operating profit
£5,600
4,000 dresses sold with advertising:
Contribution margin
£112,000
Fixed costs
94,000
Operating profit
£18,000
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.39
Using CVP Analysis (Continued)
Mary should advertise.
Operating profit increases by £12,400.
The £10,000 increase in fixed costs is offset
by the £22,400 increase in the contribution
margin.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.40
Using CVP Analysis (Continued)
Instead of advertising, management is
considering reducing the selling price to £61
per dress.
It is anticipated that this will increase sales
to 4,500 dresses.
Should Mary decrease the selling price per
dress to £61?
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.41
Using CVP Analysis (Continued)
3,200 dresses sold with no change in the
selling price:
Operating profit
£5,600
4,500 dresses sold at a reduced selling price:
Contribution margin: (4,500 × £19) £85,500
Fixed costs
84,000
Operating profit
£1,500
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.42
Using CVP Analysis (Continued)
The selling price should not be reduced
to £61.
Operating profit decreases from £5,600
to £1,500.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.43
Sensitivity Analysis and Uncertainty
Sensitivity analysis is a “what if” technique
that examines how a result will change if the
original predicted data are not achieved or if
an underlying assumption changes.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.44
Sensitivity Analysis and
Uncertainty (Continued)
Assume that Dresses by Mary can sell 4,000
dresses.
Fixed costs are £84,000.
Contribution margin ratio is 40%.
At the present time Dresses by Mary cannot
handle more than 3,500 dresses.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.45
Sensitivity Analysis and
Uncertainty (Continued)
To satisfy a demand for 4,000 dresses,
management must acquire additional space
for £6,000.
Should the additional space be acquired?
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.46
Sensitivity Analysis and
Uncertainty (Continued)
Revenues at breakeven with existing space
are £84,000 ÷ 0.40 = £210,000.
Revenues at breakeven with additional space
are £90,000 ÷ 0.40 = £225,000.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.47
Sensitivity Analysis and
Uncertainty (Continued)
Operating profit at £245,000 revenues with
existing space = (£245,000 × 0.40) – £84,000
= £14,000.
(3,500 dresses × £28) – £84,000 = £14,000.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.48
Sensitivity Analysis and
Uncertainty (Continued)
Operating profit at £280,000 revenues with
additional space = (£280,000 × 0.40) –
£90,000 = £22,000.
(4,000 dresses × £28 contribution margin)
– £90,000 = £22,000.
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008
Slide 1.3.49
End of Chapter 1.3
Based upon Bhimani, Horngren, Datar, Foster, Management and Cost Accounting, 4th Edition, © Pearson Education Limited 2008